What You Should Know About the Cyprus Controversy

People withdraw money from an ATM in the Cypriot capital Nicosia. The Cyprus government postponed a planned emergency session of parliament on Sunday to debate a controversial EU bailout.

Yesterday, European officials stunned Cypriots (and many others) by announcing a rescue package for their country that involves a levy on ALL bank deposits. The news is spreading far and wide, causing quite a bit of controversy in the process. There are also questions about what will happen next…in Cyprus and beyond.

The Context: With massively overextended banks and a stumbling economy, Cyprus is in desperate need of external funding. Like other struggling euro zone members, it turned to its European partners and the International Monetary Fund for help.

After months of negotiation, a 10 billion euros ($13 billion) bailout package was announced. It spreads the burden sharing in an unprecedented manner by including a de facto haircut on all bank deposits (de jure, depositors receive an equity claim).

The Controversy: "PSI" (private sector involvement) has been featured in other European rescue packages, but none have imposed losses on deposit holders. This one does, and it covers all deposits—through a tax that ranges from 6.75 percent to 9.99 percent, depending on the size of deposits. In addition to its highly regressive design, this element sets aside decades of convention and laws that protect bank deposits below a certain threshold (100,000 euros, in the case of the European Union).

(Read More:Facing Bailout Tax, Cypriots Try to Get Cash Out of Banks)

The Rationale: European and Cypriot officials argue that, in light of an extremely challenging situation, this was the best among the unpleasant options available to them; and seemingly they could not ignore bank depositors all together since it is their funds that inadvertently enabled the careless over-expansion of the Cypriot banking system.

There is also a feeling among European officials that Cyprus could be a lax offshore jurisdiction that intermediates funds of dubious origins. The levy counters that. It also conveys a message to peripheral countries that have been getting more complacent on the back of ECB support, a signal that hardliners within Europe have been keen to send.

The Risks for Cyprus: Citizens are furious—towards their government, European partners and the IMF—with a bank levy that covers everyone, big and small. The specification of such a small differential (6.75 percent vs 9.99 percent) adds fuel to a fire of discontent. All this serves to increase political tension and the risk of social unrest.

Other Issues: There will be lots of talk about the potential for spillovers. Among the immediate ones: Will this weekend's noise disrupt the financial tranquility that has prevailed in Europe after the ECB announced its "whatever it takes" approach to stabilizing matters; and how will the ECB and other central banks react?

Will the negative contagion be contained (after all, Cyprus is a small country) or could it spread to global equity markets that have embarked on record runs?

How will this impact the phenomenon of growing distrust between citizens and established political orders and parties? And to what extent will this influence broader investment flows?

Next Steps: The parliament in Cyprus is scheduled to meet tomorrow to discuss the bailout package. We should expect quite a bit of controversy, and quite a close outcome. The terms could be revised. There are also indications of some divisions within Europe. And the possibility of legal challenges cannot be excluded.

Mohamed El-Erian is the CEO and Co-CIO of Pimco, which oversees nearly $1.8 trillion in assets and runs the Pimco Total Return Fund, the largest bond fund in the world. His book, "When Markets Collide, " was a New York Times and Wall Street Journal bestseller, won the Financial Times/Goldman Sachs 2008 Business Book of the Year, and was named a book of the year by The Economist and one of the best business books of all time by the Independent (U.K.).